Free cash flows (FCF) used in DCF valuations discussed in the chapter are defined as follows:
FCF to debt and equity = Earnings before interest and taxes × (1-tax rate) + Depreciation and deferred taxes-Capital expenditures -/+ Increase/decrease in working capital
FCF to equity = Net income + Depreciation and deferred taxes - Capital expenditures -/+ Increase/decrease in working capital +/- Increase/decrease in debt.
Which of the following items affect free cash flows to debt and equity holders? Which affect free cash flows to equity alone? Explain why and how.
All answers assume a tax rate > 0.
An increase in accounts receivablewill cause both FCFE and FCFD+E to decrease, since it increases the firm's cash required for working capital.
A decrease in gross margins will cause both FCFE and FCFD+E, to decrease by lowering both EBIT (1 – tax rate) and NI.
An increase in property, plant, and equipment will decrease both FCFE and FCFD+E due to an increase in capital expenditures.
An increase in inventory will decrease both FCFE and FCFD+E through an increase in cash required for working capital.
Interest expense will decrease FCFE only. For calculating free cash flows to debt, additional interest expense does not change EBIT (1 – tax rate).
An increase in prepaid expenses will cause both FCFE and FCFD+E to decrease through an increase in working capital.
An increase in notes payable to the bank will increase FCFE only. The increase in notes payable will increase debt, increasing the FCFE by the same amount.
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